Commodity risk, a matter for financial risk management specialists

Commodity risk, a matter for financial risk management specialists

PART 2.

Commodity risk management is far from simple. Entrusting it to specialists seems sound. However, who better than a seasoned treasurer equipped with the right tools to manage this type of risk? No one can. The complexity of the accounting treatment and the mark-to-market revaluations (i.e., M2M) make it a special animal that few people can tame. The treasurer is one of the only ones who can do it, provided he is equipped with the right tools for the dual management of FX and commodities. One more challenge for the financial jack-of-all-trades.

The difficult job of raw materials manager

If there is one job or function that is delicate these days, it is certainly that of commodities and energy manager. The hyper-volatility of the markets is not beyond reproach. It has disturbed all the players. Hedging has become an essential factor of protection (for buyers) and sometimes a new concern (for sellers). The latter have hedged like the energy companies, without counting on the liquidity risk attached to the management of derivatives on regulated markets, which require collateral to be posted. The recent crisis of the electricity producers is a good example of a "black swan". This unfortunate episode in a "bullish" context will have undeniable and possibly painful regulatory consequences. So, we can say that this is a function that has seen difficult and complicated times. It is therefore essential and more useful than ever to be properly equipped with systems to manage this type of risk. This is what we will discuss in this paper.

Storage of data related to commodities exposure

The storage of commodity management data and the automatic link with treasury tools to cover them is essential in hedge accounting (i.e., IFRS 9 - IAS 39). We are in a world where financial and operational decisions (i.e., purchase of commodities) cannot be managed without having in mind the accounting aspect of their treatment to avoid any (undesired) volatility of the P&L. One does not play with such hedging tools without being seasoned and equipped with tools adapted to this particular management. Moreover, these commodities being traded in USD, create an additional risk for companies in functional currency other than USD. This is what can be called an "embedded risk" (a risk that is included/inserted in another) and that can hardly be treated separately to be properly managed. In addition, commodity hedging is generally done on regulated markets and therefore involves the management of collateral. This is a liquidity risk (as we have seen recently with energy companies) and an operational risk. As we can see, the risks are closely linked and require the services of a specialist. Segregating them can be a source of trouble. Moreover, who else but the treasurer has tools adapted and tailored (not all of them) for this management? 

Why using one single tool under one single management?

It seems obvious that centralized and joint management makes a lot of sense in terms of technical and expertise. One of the problems comes from the international accounting standards, i.e., IFRS and the potential application of the hedge accounting exception. IFRS9 requires regular revaluation, and we know how problematic this is for companies, especially without dedicated tools. If you want to better manage a financial risk, you must start by measuring it. And without a revaluation tool, there is no possibility of stress-testing or sensitivity analysis, which are so useful in these times. We must also add collateral management, for margin calls on regulated instruments requiring this type of collateral. This is an additional element of complexity for the management of commodity hedges.

Often, this type of risk, if not covered by a dedicated tool or an adapted TMS, will be managed on a spreadsheet. The risk becomes operational because we know the personal, fragile, and manual nature of XL, despite all the power of this tool. This is why we believe that the treasurer is perfectly qualified to manage these two embedded risks.

Hedge accounting best practices

According to International Account Standards rule (i.e., IAS 39), commodity risk may be hedged entirely or only for FX risk. But separated management and potentially no management of this specific risk are not recommendations from specialists, nor best practices. The derivatives are classified as “Held for Trading” and corrections in fair value are tracked by P&L, while swings in the fair value of contracts under the “own use” exemption are not included in P&L. These nuances can create obstacles for hedging commodity risk. For hedge accounting purposes there are typically three types of strategies: (1) Fair Value Hedge – Accounts for commodity inventory (2) Own-Use Fair Value Hedge – Accounts for commodity firm commitment & (3) Cash Flow Hedge – Accounts for commodity forecast transactions.

Before a hedge is deployed, the strategy must be assessed for “effectiveness” prospectively and retrospectively. To continuously apply the desired hedge accounting rules, the hedge must be deemed effective. Hedge effectiveness is determined by an analysis of the asset-to-derivative relationship (i.e., former correlation ratio of 0.8-to-1.25; removed). It means that ineffective portions are excluded. At the end of every reporting period, treasury officers must conduct a retrospective assessment to verify that the hedge has worked and a prospective assessment to ensure that the hedge will continue to work.

The data edge

With most corporate treasurers favoring commodity hedge strategies, the resulting accounting quandaries demand an agile data solution that can automate forecasts and risk exposures. Market uncertainties, along with new regulatory obstacles, compel treasury officers to seek technology partners that can leverage the highest quality data to create accurate risk models. As commodity-risk hedging becomes more relevant for companies seeking to reduce cash flow disruptions, automated data solutions can improve P&L and demystify accounting enigmas.

Inventory of commodities

A grasp of the inventory cycle and accounting treatment is important for understanding the correct exposure to hedge and avoiding a timing mismatch between the settlement of the hedge contracts and the impact of the price when the commodity is consumed or sold. Understanding the time from purchase of the raw material to the sale price will impact the product margin, especially where there is price flexibility, and the sale price can be increased to reflect the rising cost of the commodity.

Supply-demand

Market fundamentals are an important influence on commodity price. Disruptions to the supply of a commodity will result in upward pressure on the price until availability of the commodity exceeds demand and a surplus occurs sufficient to stabilize the market price. If the supply is far outstripping demand, suppliers looking to sell the commodity will lower the price, exerting downward pressure of the market price. In addition, the commodity markets attract a large proportion of speculators relative to the currency and interest rate markets. Speculators are not trying to hedge their exposure to minimize volatility, but are adding exposure to benefit from a perceived positive or negative movement in the commodity price.

Volatility

Another difference between currency and commodity markets is market volatility. Some markets such as gas and electricity need to be supplied in real time. Electricity storage is difficult, resulting in considerable volatility compared to currencies. While annual volatility of major currency pairs when high is about 10%, spot natural gas prices can often fluctuate more than 100% on an annualized basis. Spot power prices can jump 1,000% or more on an annualized basis, as seen in 2021 when the Texas power grid suffered weather-related power failures.

Currency

In addition to the commodity itself, the currency in which a reference commodity contract is quoted is important. For example, let’s say a company is hedging with an over-the-counter future or forward contract that is priced in US dollars, but the company’s functional currency is not USD. The company’s exposure to that commodity will change even if the quoted commodity price does not change if the USD strengthens or weakens against the company’s functional currency. It is important to understand this, because hedging against the commodity exposure using a USD-denominated forward or future will not eliminate the exposure to the hedged USD due or received at delivery.

One approach is to enter an FX swap for the nominal contract amount of USD and link the FX hedge to the commodity hedge. If the commodity exposure changes and the company moves to unwind the commodity hedge, it will also need to unwind the FX contract as well.

Keeping sales/procurement in the loop

Placing the oversight of commodity hedging within treasury requires strong communication with operations. Changes in production, contract terms, reference price, etc, can have an impact on commodity exposures. Contract term changes is an area that is often not communicated in a timely manner to the risk management group.

Dedicated technology can enormously help

Treasury departments are increasingly being requested to manage commodity hedge programs. Many already hedge interest rate risk, FX risk and counterparty exposures. It looks a natural extension of the financial risk management oversight mandate they have. Nevertheless, to efficiently manage a commodity hedging, treasurers should consider the advantages of using solutions that seamlessly integrates with the rest of its technology stack. It seems that none of the classic TMS’s are perfectly fit for commodity hedging, apart from limited exceptions. It explains why teams are still relying on EXCEL spreadsheets (with all the lack of reliability and operating risks it implies) will find themselves overwhelmed. We therefore come to a rapid conclusion: a dedicated solution managed centrally by treasury makes a lot of sense and here a solution like DEFTHEDGE may help a lot.

Fran?ois Masquelier, CEO of Simply Treasury – Luxembourg February 2023

Disclaimer: This article was prepared by Fran?ois Masquelier in his personal capacity. The opinion expressed in this article are the author’s own and do not necessarily reflect the view of the European Association of Corporate Treasurers (i.e., EACT).